Economics and Project Management By Dr.Eng. Abdelsalam M. Sharaf Eldien

CHAPTER 2 Cost Concepts

REFERENCES Blank, L. T., A. Tarquin: Engineering Economy, 6th ed., McGraw-Hill, New York. Canada, J. R., W. G. Sullivan, D. Kulonda, and J. A. White: Capital Investment Analysis for Engineering and Management, 3d ed., Pearson Prentice-Hall, Upper Saddle River, NJ. PMAC Consulting Private Limited ,Advanced Project Management Course, Global R.E.P., PMI , USA. Leland Blank, P. E., Basics of Engineering Economy, Industrial and Systems Engineering Texas A&M University. Jeremy Jay V. Lim, Project Management, Concepts and Cases. Donald G. Newnan and Ted G. Eschenbach , Engineering Economic Analysis ,Oxford University Press ,New York. Mohamed Khalifa Hassan, Project Management, Egypt.

What is Cost? •the real physical resources consumed • the money equivalent of the real physical resources used. • the value of benefits foregone in the alternative use of resources. Cost is a measure of the consequences of a decision.

Why Analyze Costs? • to compare alternatives. • to prepare budget. • to achieve economy and efficiency.

Engineering Costs Evaluating a set of feasible alternatives requires that many costs be analyzed. Examples include costs for initial investment, new construction, facility modification, general labor, parts and materials, inspection and quality, contractor and subcontractor labor, training, computer hardware and software, material handling, fixtures and tooling, data management, and technical support, as well as general support costs (overhead).

Fixed, Variable, Marginal, and Average Costs Fixed costs are constant or unchanging regardless of the level of output or activity. In contrast, variable costs depend on the level of output or activity. A marginal cost is the variable cost for one more unit, while the average cost is the total cost divided by the number of units.

For example in a production environment fixed costs, such as those for factory floor space and equipment, remain the same even though production quantity, number of employees, and level of work-in-process may vary. Labor costs are classified as a variable cost because they depend on the number of employees in the factory.

Thus fixed costs are level or constant regardless of output or activity, and variable costs are changing and related to the level of output or activity. Average cost is thus calculated by dividing the total cost for all units by the total number of units. Marginal cost is used to decide whether the additional unit should be made, purchased, or enrolled in.

Sunk Costs A sunk cost is money already spent as a result of a past decision. Sunk costs should be disregarded in our engineering economic analysis because current decisions cannot change the past. For example, dollars spent last year to purchase new production machinery is money that is sunk: the money allocated to purchase the production machinery has already been spent-there is nothing that can be done now to change that action.

As engineering economists we deal with present and future opportunities. Many times it is difficult not to be influenced by sunk costs.

Opportunity Costs An opportunity cost is associated with using a resource in one activity instead of another. Every time we use a business resource (equipment, dollars, manpower, etc.) in one activity, we give up the opportunity to use the same resources at that time in some other activity.

A formal definition of opportunity A formal definition of opportunity. An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen activity instead of engaging that same resource in the forgone activity.

Recurring and Nonrecurring Costs Recurring costs refer to any expense that is known, anticipated, and occurs at regular intervals. Nonrecurring costs are one-of-a-kind expenses that occur at irregular intervals and thus are sometimes difficult to plan for or anticipate from a budgeting perspective.

Examples of recurring costs include those for resurfacing a highway and resigning a roof. Annual expenses for maintenance and operation are also recurring expenses. Examples of nonrecurring costs include the cost of installing a new machine (including any facility modifications required), the cost of augmenting equipment based on older technology to restore its usefulness, emergency maintenance expenses, and the disposal or close-down costs associated with ending operations.

Incremental Costs One of the fundamental principles in engineering economic analysis is that in making a choice among a set of competing alternatives, focus should be placed on the differences between those alternatives. This is the concept of incremental costs. For instance, one may be interested in comparing two options to lease a vehicle for personal use.

The two lease options may have several specifics for which costs are the same. However, there may be incremental costs associated with one option not required or stipulated by the other. In comparing the two leases, the focus should be on the differences between the alternatives, not on the costs that are the same.

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